Last week I posted a comparative valuation of two unnamed companies. It wasn't hard for you to guess which the companies were, which reminds me that I will have to come up with harder cases if this is to remain a blind valuation exercise.

The comment of Seanickson (and I thank him for not revealing the names of the companies) nicely summarizes the idea of this case. Looking at the numbers, Company B is clearly the better of the two. Yet, going beyond the numbers, a look at the bigger picture would change, maybe even reverse, the decision to invest in Company B.

Selling a decent volume at a decent margin to cover your large fixed costs.

Of course, companies do all of this to generate a profit. But in the past few years, it has been a very elusive profit in electronics retail. The square footage and goods in place are generating less and less gross profit — barely enough to cover the costs of doing business (payroll, rent, advertising). Because a major part of these costs are fixed, gross margins are essential in retail.

A company can't adjust its operating structure quickly to accommodate changes in the business environment. Whether you own or lease the stores, changing their number is neither cheap nor easy. Often it is harder to reduce them than to increase them. Thus, a bloated, competitively handicapped retailer's most probable exit is bankruptcy. That's the road down which Company A went.

You have figured out from the summary data that Company A's gross margin stayed more or less constant around 24%. At the start of the observed period Circuity City was at the top of its game (No. 1 electronics retailer) and its valuation (over $13 billion in 2001). During the same period, Best Buy was quickly catching up. Company B's gross margin improved, first faster then slower, from 16% to 25%. It was clearly giving Circuit City a run for its money.

Although Best Buy only managed to reach, and never exceed by much, the level of Circuit City's gross margins. This is where volume comes into play. With the same margins but much faster growing sales volume, Best Buy soon took the No. 1 place in electronics retail. Coincidentally, at the start of the period studied both companies had very similar sales — in the $8 to 9 billion range. Nine years later, Circuit City crept up to a little over $12 billion, while Best Buy soared to a whopping $36 billion. In compound growth terms, that's 3% versus 16% annually. Losing market share at this rate is no way to stay in business.

Of course, super-fast growth does not guarantee good results. For retailers, it is very important how well they control operating expenses. Operating margins are thin by default for this industry, so shaving a couple of points can make a big difference. That's what Best Buy did. It managed to increase the 2 cents it kept from operations at the start of the period to over 5 cents. At the same time Circuit City's 3 cents slipped through its fingers until there was nothing left.

A quick DuPont breakup shows that Best Buy had larger profit margins, more turns and better use of leverage, resulting in incomparably better returns on equity.

The numbers are pretty clear.

Beyond the Numbers

Researching the qualitative side would have demonstrated that Circuit City's management became complacent, lost focus, fired its best sales people and didn't mange the real estate well. All these red flags were raised when credit finally became tight, suppliers started asking for money up front and Circuit City was not in shape to survive.

Best Buy survived. Not only that — it benefited from ousting its biggest competitor. What more can a business ask for?

The big picture matters. Selling electronics is not, in itself, a bad business. Surely, people will keep buying electronics in the future. Probably more than ever. But the changing economics of the business and the changes in consumer spending will affect how this shopping happens. With a ubiquitous retailer like Amazon — running super-efficient operations and passing the savings on to increasingly price-conscious buyers — there will be little, if any, place for big-box electronic retailers, doing business the old-fashioned way.

While the numbers describe a stable business, generating very good return on equity, the bigger picture suggests that this business is going extinct due to the disruption to its industry. It is interesting that it happened now and not earlier. Amazon (AMZN) has been around while both Circuit City and then Best Buy thrived. I think it was a combination of Amazon picking up scale and people becoming more comfortable with online shopping and much more price-conscious due to the ongoing hard times. The advent of mobile apps for instant price comparison also play a vital role.

In any case, the result was this:

BestBuy gained more than 300% over the observed period while Circuit City lost 75%.

Yet, the future wasn't bright. After becoming number one and losing its main competitor, Best Buy still went on to lose 60% of its market cap.

I think this case illustrates well why it is so important to try to imagine where the business you are analyzing could be 10 years from now. Not the precise forecasts used in DCF valuations, but more an indication that you have a good grasp on the business. If the future has too many unknowns, the company is probably for the too tough pile.

I would like to thank all the people who took part in this little exercise. It wasn't too difficult but I hope you found it as useful as I did.

I intend to keep posting — here and on my blog at StudentOfValue.com — such cases whenever I have a more interesting one to share. You can follow me on Twitter, also.

About the author:

Comments

Definitely. Any quantitative data needs to be backed up by a qualitative understanding.

I think these blind valuations things are neat puzzles. Would be more interesting to post a few basic facts about the industry so one has an idea about how stable it is, the economics, how permanent it is, etc.

Disclaimers: GuruFocus.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on GuruFocus.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The gurus may buy and sell securities before and after any particular article and report and information herein is published, with respect to the securities discussed in any article and report posted herein. In no event shall GuruFocus.com be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on GuruFocus.com, or relating to the use of, or inability to use, GuruFocus.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. The gurus listed in this website are not affiliated with GuruFocus.com, LLC.
Stock quotes provided by InterActive Data. Fundamental company data provided by Morningstar, updated daily.